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Investing in Real Estate

Investing in Real Estate

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Investing in Real Estate

ratings:
4/5 (19 ratings)
Length:
594 pages
9 hours
Publisher:
Released:
Feb 24, 2012
ISBN:
9781118240021
Format:
Book

Description

The bestselling guide to real estate, newly revised for today's investors

More than ever, investing in property today will set you on track to conquer financial uncertainty and build your long-term net worth. Investing in Real Estate, Seventh Edition offers dozens of experience- proven methods to convert these challenging times into the best of times.

Whether you want to fix and sell or buy, improve, and hold, market savvy real estate investor Gary W. Eldred shows you how to achieve your goals. He provides time-tested ways to grow a profitable portfolio and shows you how property investing can deliver twenty-two sources of financial return. You'll learn how to negotiate like a pro, read market trends, and choose from multiple possibilities to finance your properties. This timely new edition also includes:

  • Historical context to emphasize how bargain prices and near record low interest rates now combine to offer unprecedented potential for short- and long-term profits

  • Successfully navigate and meet today's loan underwriting standards

  • How to obtain discounted property prices from banks, underwater owners, and government agencies

  • How to value properties accurately—and, when necessary, intelligently challenge poorly prepared lender appraisals

  • Effective techniques to acquire REOs and short sales on favorable terms within reasonable time frames

  • How to market and manage your properties to outperform other investors

  • And much more!

Join the pros who are profiting from today's market. All you need is the knowledge edge provided by Investing in Real Estate, Seventh Edition—the most favored and reliable guide to gaining the rewards that real estate offers.

"This is the best how-to-invest-in-real-estate book available."
Robert Bruss

INVEST NOW for Large Future Gains

INVEST NOW for Increasing Cash Flows

INVEST NOW for Lifetime Security

Publisher:
Released:
Feb 24, 2012
ISBN:
9781118240021
Format:
Book

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Top quotes

  • Buy properties that you can profitably improve.

  • Yet, in all of your personal and business transactions, resist temptation. Become known as someone whose words, actions, and promises evoke trust and confidence.

  • In principle, the more you borrow, the less cash you invest in a property, the greater you magnify your returns.

  • To grow a passive, inflation-protected stream of income, own income properties.

  • Buy right time, right price, right place properties.

Book Preview

Investing in Real Estate - Gary W. Eldred

Eldred

Prologue

INVEST IN PROPERTY NOW

Invest in property now. Or forever live with your regrets.

Listen to the wealth-building wisdom of Warren Buffett: "Invest when fear, doubt, and uncertainty grip the mind of the crowd; sell when wild hopes and speculative fever burn away reason."

The emotional herding of the crowd allows you and me to buy cheap and sell dear. Think through that wise advice offered by the Sage of Omaha. What type of markets offer the best opportunities for future profits? What type of market alleviates risk? To answer these questions, contrast those boom market conditions of yesteryear with the potential-filled market we experience today:

Boom: Builders brought to market more than 2 million housing units a year.

Today: Housing starts have fallen to fewer than 400,000 per year (the lowest level of building since World War II).

Boom: Buyers crowded into open houses and model homes to beg sellers or builders to accept their above-asking-price bids. Sellers set prices. No matter how high, buyers willingly paid on the ill-founded assumption that any price would look cheap compared to 12 months later.

Today: A majority of potential investors and home buyers remain cautious, uncertain, and fearful. Open houses remain sparsely attended. To attract mere lookers, builders are slashing prices and doling out buyer concessions and incentives.

3. Boom: Interest rates averaged plus or minus 6 percent.

Today: Interest rates of 4.0 to 5.0 percent prevail (at least for now).

Boom: Inflation seemed under control as far into the future as the mind might imagine. Allan Greenspan, chairman of the Federal Reserve Board, was dubbed The Maestro for his then believed-to-be masterful handling of the money supply and interest rates.

Today: Trillions of dollars of deficits, government borrowings, and quantitative easing seem likely to push inflation (and interest rates) to much higher levels within the coming decade.

Boom: Properties sell at prices 30 to 100 percent above their replacement (construction) costs.

Today: You can buy properties at 20 to 70 percent below their cost to rebuild new.

Boom: Millions of buyers overborrow to purchase properties they cannot afford. Liars’ loans proliferate. Appraisers deliver any market value figure that buyers, loan reps, and sellers want.

Today: Tight credit and high unemployment lead many people to double up (or even triple up) on their housing. Boomerang kids and even three-generation households have increased to the highest levels since World War II. Loan reps and appraisers must comply with strict new regulations that inhibit collusion.

Boom: Most sellers can easily demand top dollar.

Today: Financial distress and millions of short sales, foreclosures, and bank REOs (real estate owned) create a ready supply of desperately motivated sellers (and lenders). Buyers—not sellers—set prices.

Boom: Property prices are propelled far above the amounts that rental income will justify.

Today: Market prices have fallen to the point where rental income yields from properties substantially exceed the income yields available from bonds and stocks (that is, interest and dividends). Investors can reasonably expect to achieve positive cash flows—either immediately or within a few years. Capitalization rates have increased. Gross rent multipliers have decreased. Rents are heading up, vacancies down.

Boom: Hundreds of thousands of new investors stretched financially and overpaid for rental properties that they did not know how to manage.

Today: Many of those same starry-eyed investors have sadly awoken to the reality that safe investing requires reserves of cash and credit, knowledge, thought, an effective operating system, and a tenant-pleasing strategy.

10. Boom: Nearly all soothsaying economists forecast blue sky prosperity without serious recession.

Today: Talk shows and financial news spew out a steady stream of gloom and doom.

[For historical perspective, recall other previous times of economic hardship such as the early to mid-1970s, the early 1980s, and even as far back as 1937—when the hoped-for Depression recovery suffered a discouraging setback (the stock market again fell more than 30 percent. Or say Texas in the late 1980s and early 1990s when the RTC (Resolution Trust Corporation) was selling masses of foreclosures and nearly all of the banks and savings and loans within the state became insolvent. Or revisit the severe recession and real estate collapse that occurred in California during the early 1990s (La Jolla houses at less than $300,000; Los Angeles condominiums at less than $100,000).

Were those so-called bad times actually good times to invest in property? No doubt about it. Investors who bought during any of those doom-and-gloom eras earned extraordinary returns for their insight and foresight. Now’s your sure opportunity to buy a winning ticket. You can match their gains. History does repeat itself. You do not need a back to the future time machine to return you to those past golden years.

Today when I travel and tell people that I live part of the year at my home in Florida, they predictably respond, Florida! The real estate market there is really bad, isn’t it?

I reply, "Bad? What do you mean, bad? You are mistaken. The Florida market today represents one of the best property markets that I have ever seen—anywhere, at any previous time. I am an investor. Relative to income and cash flows, property prices look good. Relative to risk-adjusted potential for capital gain, property prices look great."]

TODAY’S ODDS POINT DIRECTLY TOWARD PRESENT AND FUTURE GAINS

In these seemingly bleak days of the real estate cycle, fear looms. Cash balances in banks build up. Most would-be investors and savers crowd onto a flight to quality. They accept certificates of deposit (CDs) and money market accounts that pay negligibly low-single-digit interest rates. These fearful and uncertain folks think, "Who cares about return on capital? I want to feel confident that I am protecting a return of my capital."

In his perpetually popular book, The Intelligent Investor, Ben Graham (Warren Buffett’s graduate school professor at New York’s Columbia University) created the parable of Mr. Market. Mr. Market represents the crowd mentality whose moods swing like a pendulum from irrational exuberance to bewildered fear and confusion. Which market mood provides the best investment opportunities and possibilities? Which mood of Mr. Market lures investors into taking the highest degree of actual risk? Which mood of Mr. Market presents the least amount of actual risk?

Booms Enlarge Actual Risk

During the irrationally exuberant boom times, investors perceive little risk, but real risks loom larger and larger as prices climb higher and higher, rental income yields fall, and unsustainable amounts of mortgage debt pile up—even though rent collections remain too low to cover operating expenses and debt service.

During the boom in Las Vegas, so-called investors (actually speculators) believed that flipping properties for magnificent gains would never end. Few perceived that their property risks actually laid down poorer odds than the slots at Caesar’s Palace. And who but a fool (or Panglossian optimist) would borrow money to play the slots?

Yet, Las Vegas property buyers loaded up with dangerously high loan-to-value (LTV) ratios of 90, 95, and 100 percent (or more). They naïvely assumed that the future would continue to pay off those same jackpots that they had won in the recent past. Those thousands of Californians stampeding to Vegas thought they had discovered another Sutter’s Mill.

They did not see the fool’s gold. They did not comprehend why the growing gap between mortgage payments and rent levels could not persist. On typically purchased Las Vegas properties, loan payments (principal, interest, taxes, and insurance [PITI]) often approached $2,000 a month. Potential rents for these same properties would reach no more than $1,200 a month.

When such a huge alligator is chewing off your leg, you are in a world of danger (and a world of hurt). As I have often written, high debt, low rental income yields, and exaggerated hopes for outsized continuing increases in price (for stocks, gold, or properties) always trigger a reversal of fortune. (See especially my Value Investing in Real Estate, John Wiley & Sons, 2002.)

True, the hot speculative fever in Las Vegas (as well as Miami, Dubai, coastal Spain, Ajman, Dublin, Phoenix, and so on) does stand out as beyond-the-norm mania. Most other cities did not experience such heightened frenzy among both builders and buyers. Nevertheless, irrational exuberance fueled the manic moods and mind-sets of property buyers and borrowers throughout much of the United States and other countries (though, during the boom of late, not Dallas, Berlin, or Tokyo—each of these cities had suffered its own irrationally exuberant property market 15 to 20 years back, and sat out this most recent party).

With most right-brain dominant speculative buyers now knocked out of the game, today investing in real estate once again offers outstanding profit potential with vanquished risk.

Market Downturns Vanquish Market Risk

During the past five years, property prices throughout the United States (and various other countries) have fallen by 15 to 70 percent from their previous peak levels. Relative to current rent levels and replacement (construction) costs, today’s property prices offer the most favorable buying opportunities since World War II. With property prices sitting well below construction costs (for the most part), builders cannot profitably bring new product to market. Today’s investors are protected from new competition. Builders will not even ramp up to half speed until the market prices of housing increase enough to generate a decent profit margin.

To make investing even better, mortgage interest rates have fallen to less than 5 percent (though these low rates are always subject to increase). I am taking advantage of today’s property and mortgage market. During the past several months, I have purchased multiple properties (in good to excellent condition) at discounts of 50 to 65 percent off their earlier peak sales prices.

Of course, you may wonder: Is now really the time to buy? Might prices go lower? Could we encounter a double-dip recession? Will the pipeline of foreclosures flood the market with an increased number of distress sales? Even the good opportunities of today might be surpassed with even better bargains in the near future.

Possibly, yes. But, do not forget interest rates. Over a property holding period, the extra costs of higher interest rates could dwarf any savings that you might score in price. Nevertheless, if you do choose to delay, do so intelligently.

Monitor the market (foreclosures, existing home sales, interest rates, unemployment and employment figures, new construction starts, and so on). Detect turning points in the data as well as investor and buyer confidence. Intelligent monitoring and opportunistic waiting differ from inattentive procrastination. Moreover, property investing offers multiple ways to earn a good return, among which market bottom, lowest price represents only one—and not necessarily the most important—reason to invest.

Multiple Sources of Return

Journalists and their media molls (especially economists, Wall Street mavens, and mutual fund analysts), love to play the game of short-term forecasting. They do it with stocks, gold, commodities, interest rates, and, for the past 10 years, properties. Are prices climbing? Buy. Are prices falling? Get out of the game and watch from the sidelines. As they persistently obsess over short-term price movements, the media distort and confuse the idea of investing in real estate.

Contrary to media hype, most experienced and successful real estate investors do not emphasize short-term price forecasts. Instead, we typically look to an investing horizon of 3 to 10 years (or longer). We realize that property provides multiple sources of return. The smart money investors weigh, evaluate, and understand that to earn great returns, they need to achieve only several (maybe only one) sources of reward.

Here are many (but certainly not all) of the profit possibilities that property offers:

Earn price gains from appreciation (a possibility that becomes nearly certain when you buy in down markets at below-replacement-cost prices.

Earn price gains from inflation (especially when you invest while inflation rates remain subdued and obtain low interest rate financing).

Generate unleveraged cash flows.

Use leverage (financing) to magnify returns from price gains.

Use leverage (financing) to magnify returns from cash flows.

Grow equity through amortization (that is, use rent collections to pay down your loan balance).

Refinance to increase cash flows (reduce your loan payments).

Refinance to generate cash (lump sum cash-out).

Buy at a below-market price.

Sell at an above-market price.

Create value through smarter management.

Create value through savvy market strategy.

Create value by improving the location of your property.

Subdivide your bundle of property rights.

Subdivide the physical property.

Create plottage (assemblage) value.

Convert the use of the property to one that generates more revenues (for example, residential to offices, retail to office—adapt a property use to changing markets).

Convert type of tenure (for example, rental to ownership, as in rental apartments to condominiums or, as is now the case with so many fractured condo conversion projects in default, condos to rental).

Shelter cash flows from taxes.

Shelter (or defer) capital gains from taxes.

Create and sell development or redevelopment rights.

Diversify away from stocks and bonds.

I explain each of these possible sources of return in Chapter 1 and then illustrate and elaborate to varying degrees in the chapters that follow. With this extensive range of possibilities in view, you can always find profitable ways to invest in real estate.

Unlike investing (or speculating) in stocks, bonds, gold, or commodities, you can generate returns from properties through active participation (research, reasoning, knowledge, and entrepreneurial talents). When you buy stocks, you can only pray that the market price goes up, because that’s your one single possibility to receive a reasonable return.1 (Dividend yields on stocks now average around 2 percent—though many pay nothing, and a relative few pay 3 to 4 percent per year.)

Look for Solid Value—Not Necessarily a Market Bottom

Today’s markets offer multiple low-risk, high-profit possibilities. Over a time horizon of three to seven years—if you follow the principles laid out in this book—you will earn high returns. I encourage you to invest now. No one can perfectly forecast price movements during the next year or two. But today, you can find and negotiate solid investments in any market.

Two frequent mistakes block people from profiting with property: (1) they wait too long to enter and then cannot exit an irrationally exuberant market, and (2) they wait too long to take advantage of the possibilities that are theirs for the taking (that is, they perpetually procrastinate and then regret).

DEVELOP YOUR INVESTMENT PLAN

As you read through the following chapters, you will discover how to create, develop, and exploit at least 22 sources of financial returns. To buy, improve, and hold income properties—especially when you invest in difficult economic times and finance with smart leverage—does offer the surest, safest, and, yes, even the quickest way to build your net worth. But even long-term investors like me will venture along other avenues when opportunities arise.

In addition to the buy, improve, and hold houses and apartment buildings approach, other profit-generating techniques include discounted paper, commercial properties, condominium conversions, fix and flip, adaptive reuse, tax liens, mobile home parks, self-storage centers, lease options, and triple net leases. (I discuss and explain each of these techniques in later chapters.)

To secure your future—a future free from financial worries, with a life that you can live as you would like to live—property, especially property in today’s distressed markets, provides a near-certain route to personal freedom and prosperity. All that remains is for you to develop and execute your own investment plan now.

1With some properties, I have earned a yearly return on equity of 25 percent or more—without a single dollar of price gain. If not price gain, how? Cash flow, amortization, and tax shelter (albeit tax shelter was larger then than it is today).

Chapter 1

ACHIEVE A PROSPEROUS FUTURE: 22 WAYS YOU CAN EARN PROFITS WITH PROPERTY

For at least the past 20 to 25 years, financial planners, mutual fund sales reps, Wall Street promoters, and various cheerleading professors of finance (most loudly, Jeremy Siegel of the Wharton School) have championed the mantra, Stocks for the long run; Stocks for retirement. These advocates of equities assert that over the long run, stocks outperform all other types of investments. If your retirement still sits at least 10 years into the future, they advise, place 100 percent of your nest egg in stocks. (Admittedly, the 2011 bull market in bonds converted a few of the stock market enthusiasts to a more balanced view—but the majority seem undaunted.)

In his widely read (and praised) book, Winning the Loser’s Game, Charles Ellis encourages investors to place all of their money in stock index funds rather than property because (according to Ellis),

Owning residential real estate is not a great investment. Over the past 20 years, home prices have risen less than the consumer price index and have returned less than Treasury bills. . . . Own a home as a place to live, not as an investment.

Leave aside for a moment how Ellis arrived at his long-term house price figures—no data that I have seen (even if we factor in the recent downturn) report that long-term housing prices, relative to incomes or consumer prices, have become cheaper. However, Ellis errs most egregiously in another way. He does not understand how investors should measure the total potential returns that property offers.1

Neither Ellis, stock market enthusiasts, financial planners, nor you should evaluate property returns (past or future) simply on the basis of historical or expected price growth.

Frequently, even advocates of real estate investing often err in a similar way. I often read property investing advice such as, Always buy from a motivated seller; Never buy unless you can buy at least 20 percent below market value; Always buy in an area poised for growth (or experiencing rapid growth). Unfortunately, this stock market mentality that focuses upon price growth has infected the way too many people think about property.

22 SOURCES OF PROFIT FROM INVESTMENT PROPERTY

No question about it. I love price gains and will elaborate on this point as my next topic. Nevertheless, as you evaluate properties as investments, expand your perspective. Apply each one of the potential returns listed in the prologue and explained with examples in this chapter. You can achieve stock market–beating returns from property—at much lower levels of risk—in many different ways. When you fail to evaluate the full potential of a property, you not only bypass properties that could yield great profits (albeit in ways you may never thought of), you also slight the full range of profit possibilities that lie within the properties that you do buy.

Will the Property Experience Price Gains from Appreciation?

Passive price gains (as contrasted to gains from actively creating value) can arise from two unique sources: (1) appreciation and (2) inflation. Yet, in everyday conversation, most people do not differentiate between price gains that result from appreciation and those that result from inflation. Appreciation occurs when demand for a specific type of property, location, or both, grows faster than the supply of competing (substitute) properties, whereas inflation tends to push property prices up—even if demand and supply remain in balance (although in cities such as Detroit or Buffalo, demand may slide so much that property prices lag the Consumer Price Index by a wide margin).

Homes in Central London, San Francisco’s Pacific Heights, and Brooklyn’s Williamsburg have experienced extraordinarily high rates of demand growth during the past 15 to 20 years. And since 1990, houses within a mile of the University of Florida campus have more than doubled (and in some cases tripled) in market price—primarily because UF students and faculty alike now prefer walk or bike to campus locations.

Areas Differ in Their Rate of Appreciation. Although properties located in Pacific Heights and Williamsburg have jumped in price at rates much greater than the rise in the Consumer Price Index (CPI), some neighborhoods in Detroit have suffered price declines of 60 to 90 percent. Appreciation does not occur uniformly or randomly. You can forecast appreciation potential using the right place, right time, right price methodology discussed in Chapter 15.

Likewise, you need not get caught in the severe, long-term downdrafts in prices that plague cities and neighborhoods that lose their economic base of jobs. Just as various socioeconomic factors point to right time, right place, right price, similar indicators can signal wrong place, wrong time, and wrong price.

Today’s property markets seem to offer a best-of-both-worlds opportunity: You can earn good returns from cash flow—and good returns from appreciation when the economy and property supply and demand balances return to normal. In the past, in markets strong in longer-term appreciation potential (for example, coastal California or as with urban Vancouver now), investors had to sacrifice cash flow as a trade-off for expected price gain. Fortunately, that trade-off no longer exists to the degree that it used to.

You Do Not Need Appreciation. Should you invest in properties that are located in areas poised for above-average appreciation? Not necessarily. Some investors own rental properties in deteriorating areas—yet still have built up multimillion-dollar net worths. My first properties did not gain much from price increases (appreciation or inflation)—but they consistently cash-flowed like a slot machine payoff. With one of my early apartment buildings, a $10,000 down payment grew into $100,000 of equity over 10 years—just through mortgage amortization.

When you choose a quick turn, fix, and sell strategy, appreciation isn’t needed. You achieve gains in equity that are unrelated to market temperature. Appreciation isn’t necessarily required, either, when you buy at a price 15 to 30 percent below market value. Savvy buying can reward you with five years of appreciation-like price gains—instantly upon purchase. Throw out the popular (but erroneous) belief that you can’t make good money with property unless its market price appreciates. Appreciation represents one highly rewarding goal to achieve, but by no means is it the only goal that counts.

Will You Gain Price Increases from Inflation?

In his book, Irrational Exuberance, the oft-quoted Yale economist, Robert Shiller, concludes (as does Charles Ellis, cited earlier) that houses perform poorly as investments. According to Shiller’s reckoning, since 1948, the real (inflation-adjusted) price growth in housing has averaged around 1—at best 2—percent a year.

Even if this $16,000 house [bought in 1948] sold in 2004, says the eminent professor, "at a price of $360,000, it still does not imply great returns on this investment . . . a real (that is, inflation-adjusted) annual rate of increase of a little under 2 percent a year." (Note that Shiller also omits rental income from his supposed investment results.)

Shiller Thinks Like an Economist, Not an Investor. Every investor wants to protect his wealth from the corrosive power of unexpected inflation. Even if we accept Shiller’s inflation-adjusted rate of price growth—and I believe it reasonable (on average—though savvy investors need not accept average), yet certainly not beyond critique—even Shiller’s data show that property prices have kept investors ahead of inflation in every decade throughout the past 75 years.

[Side Note: Not true for stocks (or bonds). Consider the most inflationary period in U.S. history: 1966–1982. In 1966, the median price of a house equaled $25,000; the Dow Jones Index (DJIA) hit 1,000. During the subsequent 18 years, the CPI climbed steadily from 100 to 300. In 1982, the median price of a house had risen to $72,000; the 1982 DJIA closed the year at 780—below its nominal level of 18 years earlier.]

Inflation Risk: Property Has Protected Better than Stocks. No one knows what the future holds. Will the CPI once again start climbing at a steeper pace? At the runaway rate at which the U.S. government prints money and floats new debt, the odds weight the scale in that direction. During periods of accelerating inflation, most people would rejoice at staying even. In fact, the popularity of Treasury inflation-protected securities (TIPS) reveals that goal (and worry).

Imagine that in the early to mid-1960s you were a true-blue stocks for retirement kind of investor—and you were then age 45. In 1982, as you approach age 65, your inflation-adjusted net worth sits at maybe 30 percent of the amount you had hoped and planned to accumulate. What do you do? Stay on the job another 10 years? Sell the homestead and downsize? Borrow money from a wealthy friend who invested in property?

Property Investors Do Not Buy Indexes and Averages. Economists calculate in the nether land of aggregates and averages. Investors buy specific properties according to their personal investment objectives. An economist’s average does not capture the actual price gains (inflation plus appreciation) that real investors can earn—when they set price gain as their prime financial objective. Investors apply some variant of right time, right place, right price methodologies (see p. 315). If you want to outperform the average price increases of real estate—even though the long-term averages themselves look good—you can. And today’s housing markets (especially) offer the right time to greatly outperform with long-term price growth (appreciation plus inflation).

Earn Good Returns from Cash Flows

Unlike the overwhelming majority of stocks, income properties typically yield (unleveraged) cash flows of 5 to 12 percent per year.2 If you own a $1,000,000 property free and clear of financing, you can pocket $50,000 to $120,000 a year (mostly tax sheltered; see the following discussion). If you own a $1,000,000 portfolio of stocks, you might pocket cash flows (dividend payments) of $15,000 to $30,000 a year (fully taxable—although at the time this chapter was written, the income tax rate on dividends was just 15 percent, many in Congress would like to increase this rate).

Historically, the largest source of return for unleveraged properties has come from cash flow. Remember, too, rent increases add to the profit potential of cash flows. To grow a passive, inflation-protected stream of income, own income properties.

Economists and financial planners greatly embarrass themselves when they slight or ignore this critical source of return. Before Charles Ellis, Robert Shiller, and others of their ilk again take up their pens to write on real estate returns, they might set aside their misguided claims of expertise and first learn the actual practice of investing in real estate. If they did, they would also learn that nearly all property investors magnify their returns (cash flows and equity buildup) with leverage.

Magnify Your Equity Gains with Leverage

Misguided economists, financial analysts, and various media-anointed experts claim that property provides investors real (inflation-adjusted) returns of 1 to 2 percent a year. In doing so, these advisors omit the return-boosting power of OPM (other people’s money—typically, bank or seller financing).

Low Rates of Price Gain Create Big (Inflation-Adjusted) Returns. Assume you acquire a $100,000 property. You borrow $80,000 and place $20,000 as down payment. During the following five years, we experience inflation similar to the late 1970s. The CPI advances by 50 percent. Your property’s price, though, lagged the CPI. It increased by only 25 percent. Your real (inflation-adjusted) wealth fell, right? That’s what Shiller, the economist, would conclude. But no, your real wealth increased.

You now own a property worth $125,000, but your equity wealth—your original $20,000 cash equity in the property—has increased more than 100 percent—to $45,000 (not including repayment of principal, that is, amortization). You more than doubled your money. To have stayed even with the CPI, your equity needed to grow from $20,000 to only $30,000 (a 50 percent increase to match the gain of the CPI).

Acorns into Oak Trees. Real estate investing builds equity because it grows acorns (relatively small down payments) into free and clear properties worth many multiples of the original amounts of invested cash. Let’s go back to Shiller’s house purchase example.

The homebuyer paid a price of $16,000 in 1948. Did that homebuyer pay cash? Not likely. Ten to 20 percent down then set the norm—say, 20 percent or $3,200 (.2 × $16,000). At Shiller’s hypothetical 2004 value of $360,000, the homebuyer multiplied his original investment more than 100 times over. Even if the 2004 property value comes in at $180,000—the homeowner enjoyed a nearly 60-fold increase of his $3,200 down payment. (Of course, in 1948 some homebuyers could have used a nothing-down VA loan or a 3 percent down FHA mortgage. Their gains from OPM would have paid back much greater multiples of their original investment.)

What about stock gains during that period of 1948 to 2004? In 1948, the Dow Jones Industrial Average (DJIA) hovered around 200 (by the way, it was then still about 40 percent below its 1929 peak of 360). In 2004, the DJIA stood at about 8,000—a 40-fold gain. Not bad, but still less than the equity gains from property ownership (and much, much less when we bring cash flows and tax shelter into the return comparison). [Note: When I wrote this chapter in late 2011, the DJIA still sat at around 11,500, whereas property prices (in all but the most distressed areas) are still way up from 1999, which is the year that the DJIA first hit 11,500.]

Magnify Returns from Cash Flows with Leverage

Traditionally, investors not only magnify their equity gains from leverage (mortgage financing), they also magnify their rates of return from cash flows. You pay $1,000,000 cash for an apartment building that yields a net income (after all operating expenses) of 7.5 percent (no financing). Quite good when compared to CD interest rates of 1 to 2 percent, dividend yields from stocks of 2 percent, corporate bond interest of 4 to 5 percent, or 10-year Treasuries at 2 to 2.5 percent interest. Yet it gets better. If you finance $800,000 of that $1,000,000 purchase price at, say, 30 years, 5.75 percent interest, you invest just $200,000 in cash. Your net income equals $75,000 (.075 × 1,000,000) and your annual mortgage payments (debt service) will total around $56,000. You pocket $19,000 ($75,000 less $56,000). You’ve boosted your cash flow return (called cash on cash) from 7.5 percent to 9.5 percent ($19,000 divided by $200,000). You can achieve positive leverage with cash flows whenever your cap rate exceeds your mortgage loan constant (see Chapter 2).

Build Wealth through Mortgage Payoff

Assume for a moment that from your $1,000,000 apartment building, you pocket no cash flows. You pay every dollar of net operating income (and future rent increases) to reduce your mortgage balance of $800,000. After 20 years, you have paid off (fully amortized) your loan and own your property free and clear (a workable strategy). This apartment building experienced no gain in price. At the end of 20 years, its value equals your original purchase of $1,000,000.

No price gains from inflation, no price gains from appreciation, and no money pocketed from cash flows. Quite pessimistic, right? Yet, just from amortization over a 20-year period, you grew your equity from $200,000 to $1,000,000—a five-fold gain and annual compound growth rate of more than 8 percent. In today’s low-rate world, an 8 percent return sounds pretty appealing. After 20 years, you pocket 100 percent of your net operating income—quite likely enough to live on comfortably.

Your tenants just bought you a $1,000,000 property. That’s why I tell my college students, Rent or buy? asks the wrong question. Everyone buys—the real question is one of ownership. If you rent, you pay your landlord’s mortgage. Your landlord reaps the rewards of ownership—while tenants pay the costs. Seems to me a good deal for property investors.

Over Time, Returns from Rents Go Up

Most property owners raise their rents. Maybe not this year. Maybe not next year. But over a period of five years or more, increasing rents yield increasing cash flows. If you’ve selected a right time, right place, right price property, demand will push rents up as more people want to live in the neighborhood where your property is located. Or perhaps, as government floods the economy with paper money, inflationary pressures force rents up. Either way, you gain. In fact, you can gain even if your rent increases fail to match the inflationary jumps in your expenses.

Return to our apartment building example. Gross rent collections equal $125,000; net operating income equals $75,000; mortgage payments equal $56,000; your cash flow equals $19,000.

First, assume your rents and expenses each increase by 8 percent. Here are the revised amounts:

An 8 percent increase in rents and expenses boosts your cash flow by 31 percent:

25,000 ÷ 19,000 = 13.1

If expenses had increased by 12 percent and rents stepped up mildly by just 6 percent per annum (p.a.), you would still increase your cash flow:

20,500 ÷ 19,000 = 1.08

Caution: Engage your brainpower. Run multiple outcomes with these figures and other numbers presented throughout this chapter (and following chapters). No one guarantees the results that you want or expect. Through market and entrepreneurial analysis, you estimate, negotiate, execute, and create the potential returns for the properties you buy. (Nevertheless, these examples do illustrate the time-tested principles and advantages of property investing.)

Envision each return possibility that property investing offers. Then as you evaluate markets, properties, and the outlook for your geographic areas of interest, figure the probabilities. Which of the listed (p. xxvi) sources of return look most promising? Which sources of return seem remote?

What risks could throw ice water against your expectations? What if interest rates increase? What if a local employer lays off hundreds (or thousands) of employees? What if tight local government budgets drive up property taxes? What if vacancies increase or rent collections fall, or both? Even though you can build your net worth with property with more safety and certainty than any other asset, such wealth does not accumulate automatically—or without some turbulence along the way. Anticipate potential storms: safety belts and life jackets are mandatory.

In a majority of cases, today’s foreclosures have resulted because many unwise borrowers projected that blue skies and smooth flying would last forever. It never does. As Chapter 2 discusses, the property mentors, gurus, loan reps, banks, and authors who widely promoted No cash, no credit, no problem actually promoted their own immediate profits at the expense of their naïve and trusting customers.

Refinance to Lift Your Cash Flows

Increase your rents (or decrease your property’s operating expenses, or both) and you increase your property’s cash flows. But you also gain additional cash flow when you refinance your loan at a lower interest rate or for a longer term than the years remaining on your current loan. When might a refinance pay off with a lower interest rate?

First, if market rates fall—perhaps not likely from today’s low levels. Yet, that’s what most experts said when mortgage interest rates fell back to 6 percent during the early 2000s. So, who knows? Moreover, at some future time, we might again see mortgage interest rates of 7 to 10 percent. Under those market conditions, a refinance of a property purchase as those higher rates come back down becomes ever more attractive and cash generating.

Second, not everyone qualifies for the lowest interest rates available. Credit counts. Many credit-challenged investors accept higher interest rates at the time of purchase, then refinance as they build more equity in their property; establish a higher credit score; or the credit-damaging, adverse events (bankruptcy, foreclosure, late payments, judgments, and so on) are dropped from the credit bureaus’ reporting files.

Third, LTV (loan-to-value) ratios influence interest rates. To maximize leverage, finance with a higher-interest-rate, higher-LTV loan. Then, as you build more equity in the property (inflation, appreciation, creating value, amortization, and so on), refinance your loan’s existing balance. With more equity (which means a lower LTV), the lender may grant you a lower interest rate.

In addition to reducing payment amounts by refinancing into a lower interest rate, you can increase your cash flow (decrease mortgage payments) by refinancing into a longer term. Say your loan shows a current balance of $435,000 with 14 years remaining. Extend the term of your new loan to 30 years and your payments drop by 20 to 35 percent. (The exact amount of reduction depends on the terms and amount originally borrowed.)

Some investors want quick loan payoffs. Others want to maximize cash flow and cash-on-cash return. It’s your call. But the point is that refinancing can place extra cash income into your pocket—if that’s what you prefer. (We go through some payment examples in Chapter 2.

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